Is it the Right Time to Invest in Real Estate?

Despite expecting a pullback in the market, it was up another 2.3% in April.

In fact, the market has gone on to hit a record high last Friday. The S&P500 (a representative index of the US stock market) has seen amazing gains this year, up more than 10%.

The stock market has been quite resilient this year.  It shook off the recent Boston bombings as well as the sudden drop in gold prices.

But this sort of performance is usually followed by a pull back, as the market digests its gains. And because of the time of year, that’s what everyone expects.

Between the summer months of May through September, there’s usually a lull in the market. People  are on vacation and summer stock market rallies are rare. In fact, the market often sees a summer swoon, which has resulted in the “Sell in May, and go away” theory.

One concerned client wondered if that was a good strategy to follow, especially considering this years excellent performance. We addressed that very valid concern in one this month’s articles.

While summer is bad for stocks, it’s usually very good for real estate. And everyone seems quite bullish on it right now.

Over the past few months, I’ve come across a lot of news about how real estate has turned a corner and how prices are up in many metros across the country.

In February, the average home price increased 10.2%. This marks the 12^th month of consistent gains. Stocks like Home Depot are at all-time highs and home builders are at the highest level in five years. The latest edition of Bloomberg BusinessWeek had an article about people are lining up to bid on houses just like in 2007.

Phoenix is up 23% in the past year, San Francisco is up 19% and Las Vegas is up 17.6%.

Yes, the economy is recovering, but is a 20%+ increase in home prices sustainable, or even justified?

In my opinion, the spike in home prices is driven more by an artificial constraining of supply than a real growth in demand.

Private equity firms like Black Rock and Colony Capital have bought over $5 billion worth of houses in the past six months for the sole purpose of renting them out.

As the number of rentals has increased, the rents have dropped and the vacancy rates have skyrocketed.

Rents in Phoenix are down 10% from last year. In San Francisco, it’s 29% cheaper to rent than to own a property. The vacancy rates for Colony Capital’s rentals are reportedly 40%. Since their borrowing costs are so low, and their pockets are so deep, they can afford to keep a house vacant for five months. Individual investors might not be so lucky.

The valuation of any investment is determined from the revenue it generates. For real estate, the value comes from the rental income. If the rental income drops, the property becomes less valuable and the price should drop, not increase.

If the economy is growing at a fast clip and people’s incomes are growing faster than inflation, then these numbers don’t look too bad.

However, compared to 2007, more people are unemployed and the median household income is nearly 7.3% lower than it was in December 2007.

Additionally, any increase in interest rates will put additional pressure on home buyers, since the mortgage carrying cost will be higher.

Until these factors are mitigated, I’d be skeptical of any housing recovery that’s driven by private equity investors.

As an owner of investment real estate myself, I have first-hand experience of all the issues that can arise with rental property.

This past November, I spent 7% of the value of a property on repairs after a tenant trashed the place and moved out. Coupled with the loss of two months rental income, my net income for the whole year was less than 1 month’s rent. Not exactly a hassle-free investment.

This doesn’t mean you shouldn’t buy real estate. There are significant tax benefits for owning your own home, and you always need a place to live.

But if you’re in the market for a rental property, you should be careful.

Unless you’re personally managing the property, your actual returns will vary. As an investment asset class, the amount of personal attention required often offsets the attractiveness of returns. Coupled with the illiquid nature of it, sometimes it’s just not worth it.

If you’re a busy person, you’re probably better off getting exposure to real estate through Real Estate Investment Trusts (REITs). REITs are liquid, publicly traded companies which give you access to various commercial, residential, industrial and health-care properties. They pass on nearly all of the income, offering decent yields, without any of the maintenance hassle.

However, if you’re keen on buying actual rental properties, I advise you to make sure you run the numbers thoroughly, and keep a little bit of cash in reserves for unexpected expenses.

For our existing clients, I’m happy to use my extensive real estate experience and knowledge to advise them on any real estate deals they might be looking at.

But as I said earlier, unless you’re buying your primary residence, I’d be wary of buying real estate as an investment just yet.